The problem with Microsoft...

No one questions CEO Steve Ballmer’s drive or intentions – but is his devotion to the company and its Windows business hurting its ability to innovate?

By Gary Rivlin, contributor

It seemed a little like love when a blogger named The Paperboy got his hands on a secret device being developed inside Microsoft under the code name Courier. With its icon-rich user interface and multitouch, stylus-friendly screens, Courier represented “an astonishing take on the tablet,” gushed Paperboy’s post on Gizmodo in the fall of 2009, around the time techies were buzzing about Apple’s forthcoming tablet. “Maybe,” Paperboy wrote, “we’ve all been dreaming about the wrong device.”

The Microsoft (MSFT) team working on Courier was equally jazzed. “We had a breakout product that had the potential to really delight the user,” says Rebecca Norlander, a star programmer inside Microsoft who quit last June after 19 years with the company. Just as important, Courier held the promise of catapulting Microsoft into mobile devices, a lucrative field that had eluded Microsoft for 15 years — and where rivals Apple (AAPL) and Google (GOOG) had made significant inroads.

So when Robbie Bach, who led the company’s entertainment and devices division at the time, presented his idea to CEO Steve Ballmer and Microsoft’s senior leadership, he expected enthusiasm and additional funding for the project. There was just one problem: The Courier prototype borrowed from Windows, Microsoft’s vaunted computer operating systems, but had an operating system all its own. (That’s what Apple did with its iPhone and iPad — it built a new operating platform based on its existing Mac OS X.)

Bach learned a hard lesson about the power and might of Windows within Microsoft. Not only would Bach not receive the extra funding he sought, said Ballmer, who personally delivered the blow, but there would be no Courier because it was unnecessary. The best of Courier, where appropriate, would be folded into the next version of Windows, Windows 8, due at the end of 2011 or in 2012 — or maybe even Windows 9. Several months after its death, Bach announced his retirement. (He wouldn’t comment for this story.)

To some longtime Microsoft veterans, Ballmer’s swift termination of Courier symbolizes a shortsightedness that has plagued the company’s top management in recent years — and has left the company eating Apple’s dust. (And Google’s. And Amazon’s (AMZN).) Ballmer, a preternaturally optimistic man not inclined to second-guess himself, has been forced to publicly acknowledge many of the company’s biggest misses. The Vista operating system frustrated users. The MP3 player, the Zune, has proved a dud. And then there’s Microsoft’s costliest blunder, its also-ran status on the device that is emerging as the personal computer of the 21st century, the mobile phone. “We were ahead of this game, and now we find ourselves No. 5 in the market,” Ballmer said at a tech conference in June. “We missed a whole cycle.” Or two. Or three.

But the root of Microsoft’s paralysis seems to be Ballmer himself. Interviews with a range of former Microsoft employees — from ex–vice presidents still on good terms with their former boss to middle managers and engineers who helped build the company — paint a picture of an executive determined to protect the legacy (and legacy businesses) he inherited from founder and friend Bill Gates.

Gates, who owns more than half a billion shares of Microsoft stock, declined through a spokesman to comment, as did Ballmer. A Microsoft spokesman also declined to respond to the criticisms in this article.

Former employees and analysts say Ballmer’s deep pride in Microsoft leads him to dismiss rivals’ good ideas (“There’s no chance that the iPhone is going to get any significant market share”) and to suffocate anything, such as Courier, that might detract from Windows, despite the billions the company spends each year on R&D and acquisitions.

By all accounts, Ballmer, 55, is not adept at nurturing innovation. Then again, until recently, he didn’t really have to be: Windows’ profitability — it generated an eye-popping $13 billion in profits on $18 billion in sales last year — more than made up for the absence of a portfolio of cool phones, music players, and tablets. But the Windows juggernaut simply isn’t wowing investors the way it did in the 1980s and ’90s. Though Microsoft’s sales have doubled over the past eight years, as have its profits — and net cash from operations last year rose 26% to $24 billion — the company’s stock has remained tethered to $25 a share. A share of Apple, arguably the most innovative tech company on the planet, is worth more than 20 times its 2002 price. Even Oracle (ORCL) and HP (HPQ) have seen their share prices double. Only a handful of major tech companies have performed worse than Microsoft in that time. Among them: Intel (INTC) and Ballmer’s onetime acquisition target (and now partner) Yahoo (YHOO).

Clear vision, cloudy execution

Microsoft has entered new businesses successfully during Ballmer’s 11-year tenure as CEO. It has become a major player in the data center, selling server software, database products, and other specialized software packages that satisfy the demanding needs of large corporations — “the enterprise,” in industry-speak. Under Ballmer, a relentless salesman as persistent as a piston striking steel, Microsoft’s enterprise-software division generated $15 billion in sales last year and more than $5 billion in profits.

The company also is embracing cloud computing with a splashy, if not silly, TV ad campaign (“To the cloud!”) and Azure, a web-based software product that aims to let Windows-based businesses outsource supercomputing needs to Microsoft. The company will custom-build a turnkey data center for a business or, even better, manage the cloud on its behalf — for a steep fee.

“We think we have a unique solution and a unique position, given our strength in the enterprise,” says Craig Mundie, the company’s chief research and strategy officer.

Bing, Microsoft’s revamped search engine is impressing reviewers even if it’s barely making a dent in Google’s dominance over search. The Xbox gaming system still hasn’t made back the $6 billion or so Microsoft invested in developing the platform, but it is a bona fide hit, with products in more than 50 million homes worldwide — and Kinect, its new Xbox add-on, shipped more than 10 million units, Microsoft said, an astonishing figure for a product on the market since only November. Earlier this year Microsoft scored a major coup when Finnish phonemaker Nokia announced it would ditch its own smartphone operating system in favor of Microsoft’s.

Indeed, Microsoft has always been adept at spotting technological trends. There’s no doubting it has the engineering prowess to innovate. Repeatedly, though, the company has failed to turn its smart ideas and experiments into successful products beloved by consumers. (And these days the buzz — and market premium — is going to consumer technology innovators.) Bill Gates, for example, has been talking about a tablet computer for at least 15 years, but that has translated into utilitarian devices designed for insurance adjusters and warehouse workers. Microsoft even started working on an eReader 10 years ago but, according to former executive Dick Brass, who wrote about the experience in the pages of the New York Times, it, like Courier, was sacrificed to the Windows gods. “The big established groups are allowed to prey upon emerging teams [and] belittle their efforts,” he wrote. In 2010, Ray Ozzie, the man who took Bill Gates’ place as the company’s chief software architect, called it quits after a frustrating five years, but not before offering this harsh assessment in a farewell memo: “Our early and clear vision notwithstanding, execution [by competitors] has surpassed our own.”

A phone strategy goes awry

There was a time when Ballmer seemed willing to veer from a Windows-fits-all solution, at least for mobile phones. In 2008, amid much fanfare, Microsoft acquired mobile-technology company Danger, developer of the Sidekick, a phone once so hot that Snoop Dogg and Paris Hilton were among its celebrity endorsers. (Danger was founded by Andy Rubin, who also founded Android, which has fared far differently under Google than Danger did under Microsoft.) Microsoft folded Danger, which developed a Java-based software for its phones, into a secret team code-named Pink. The deal had not officially closed when Microsoft executive Matt Bencke met with Danger team members. “He says to us, ‘We’re going to put jet fuel on the Danger fire,’ ” according to one person who was at the meeting. “To everyone at Danger, we heard that as ‘You’ve got this great product, and we’re going to give you the resources to take this to the next level.’ ”

Two months later Dangerites learned that that had been wishful thinking on their part. Most of them would be helping others inside the company develop a new Windows-based phone aimed at tweens and called the Kin. (Bencke declined comment through a Microsoft spokesperson.) One disaster followed another. A larger team inside the company was working on an operating system called Windows Phone 7 to compete with Apple’s iOS and Google’s Android. Initially the Kin team was told its phone needed to work atop the Windows Phone 7 OS — except the deadline for Windows Phone 7 slipped. The Kin team was forced to do the best it could with a partially built version of the company’s new phone OS.

“They paid all this money for our industry know-how and our experience, but basically no one listened to us,” says Cid Halloway, who joined Danger in 2001 as a senior software engineer. Halloway tried to make suggestions when he could, but that only seemed to grate on people. “A few people openly said to us, ‘We think you got lucky with Sidekick, so sit down, stop talking, and do what we hired you to do.’

“It was not a happy few years,” Halloway said of his 30 months at Microsoft before his departure this past fall.

Microsoft released the Kin in April 2010. The phones were stylish, but the service, at a minimum cost of $70 a month, was expensive, and reviews were tepid. For a device aimed at tweens it missed the mark: It didn’t have instant messaging, it couldn’t play YouTube videos, and users couldn’t buy online games. Only 48 days after the Kin hit stores, Microsoft announced it was discontinuing the phone. Insiders say Microsoft spent at least $1 billion and probably closer to $2 billion developing and marketing the Kin.

To many inside and outside Microsoft, the Kin debacle is another example of how Ballmer, an otherwise sharp and intuitive leader, seems colorblind and tone-deaf when it comes to anything consumer-oriented — a big challenge given the role consumers are playing in dictating corporations’ technology decisions. “You need people in charge who are able to say, ‘You know what, we’ve spent a lot of money on this, but we’ve got to dump this before it really hurts our reputation,’ ” says a former executive.

Licking the cookie

Inside Microsoft it’s known as “licking the cookie.” That’s when a group within the company, typically Windows, declares its intentions to work on a feature or a product, thereby preventing others within the company from taking it on. Often it makes sense for Windows to own a project, says a former Microsoft manager who still does consulting work for the company, but it also slows down development at a time when tech companies can scarcely afford to be piggy.

Others talk about what a few former employees call the “made men” — those who earned their bones during the 1990s when Microsoft was riding high and now can do no wrong, even as they bungle decision after decision. “You want to innovate in mobile?” said a former top Microsoft engineer named James Whittaker before leaving to take a job at Google. “Then deal with the made men who run the relevant cartel. And if they don’t like you or your idea, your innovation goes nowhere.”

Rob Sanfilippo thinks former colleagues can be too harsh in their judgments. Sanfilippo, who spent 14 years at Microsoft, monitors his old company for Directions on Microsoft, a consulting firm based in Kirkland, Wash. He feels that the company has had its misses, sure, but there’s also the innovation that goes into new releases of everything from Windows to the Exchange servers that handle a large share of the Internet’s e-mail. Those upgrades generally garner strong reviews, and the company has done what’s needed to play defense against Google and other companies trying to take market share from Office and Windows. In any number of areas, Sanfilippo says, “the company is on top of its game.”

Yet even Sanfilippo thinks Microsoft has clung too long to the magic of the Windows brand. “At some point they have to realize they can’t just keep putting Windows on these different devices and expect it to be appropriate,” he says.

Some ex-employees say the answer is for Microsoft to break apart. At one time Charles Fitzgerald, a product manager before leaving the company in 2008, would have snarled at anyone daring to agree with the Department of Justice that Microsoft should be split into “baby Bills.” But now Fitzgerald, a top executive at the software firm VMware, recommends splitting Microsoft into six smaller companies. Let Windows lick all the cookies it wants as its own freestanding company. Unleash Office so that it can create apps for the iPad and Android without having to put Windows first. If it were on its own, a business-software company could be more platform-agnostic and better challenge Oracle and SAP (SAP) for the enterprise customer; those in charge of products like Bing or Xbox would need to learn to survive on their own, at least once they burned through the cash they would inherit as a cushion against the harshness of their newfound independence. Others have devised a less elaborate solution: Let Microsoft do what it does best — provide software to businesses — and sell off its consumer-oriented units.

Ballmer has scoffed at suggestions that Microsoft spin off its consumer business. Speaking at an industry conference in October, Ballmer called Goldman analyst Sarah Friar “nutty” for proposing just that when she downgraded Microsoft’s stock, and he dubbed her suggestion “the second most crazy idea I have ever heard.” (He gave no indication of his top choice. Friar has since left Goldman.)

Still, Ballmer needs to do something to shake Microsoft from what, at best, seems to be a textbook case of corporate ennui: MIT’s Michael Cusumano, who has featured Microsoft in several books, including the new work Staying Power, sees a company hopelessly stuck in neutral, in no small part because Microsoft has a weak board and no one expects Bill Gates, the company’s top shareholder, with about 5% of shares outstanding, to oust the CEO, who was the best man at his wedding. “Ballmer has been a good steward of Windows, and that’s about it,” Cusumano says.

Is it too late for Microsoft? Certainly the company has made it harder for itself by squandering big leads. But it’s still early in the competition for the tablet market, and the fight for majority rule in the phone sector began in earnest only four years ago with the first release of the iPhone. Companies with bigger hurdles to overcome than Microsoft (which sits on an amazing $44 billion in cash) have reinvented themselves. Apple may be the most famous comeback in technology, but Motorola (MSI) and Netflix (NFLX) have also come back from near-death experiences. The reason: strong leadership, and a willingness to cast off the past in favor of an uncertain but promising future.